On Wednesday this week the S&P 500 plunged by 3 percent on cumulative fears of slowing economic and earnings growth as well as concerns of a slowdown in China and the Federal Reserve being too aggressive in increasing short-term interest rates. This decline was followed by a 2 percent positive move on Thursday and another decline of more than 1 percent on Friday. Overall, the market has declined nearly 10 percent from its recent high, getting into the territory of a correction which is defined as a decline of 10 percent. While the volatility has been jarring, we believe that this is a normal correction and not signaling a recession or the start of a bear market. Roughly 40 percent of the S&P 500 companies have reported earnings for the third quarter of 2018, and earnings growth is robust - up more than 20 percent on a year-over-year basis. In addition, 82 percent of companies reporting have released results that are in excess of the consensus. Despite this impressive gain in earnings, investors have become skeptical and any company that has fallen short of expectations has been severely punished.
Third quarter GDP growth was 3.5 percent which exceeded the estimate of 3.3 percent. Both consumer spending and government spending contributed to the solid quarter of growth. The GDP growth for the third quarter was lower than the second quarter of 2018 which came in at more than 4 percent. The economy is still expanding, but at a slower rate.
It is important to note that global GDP and earnings continue to grow as well but at a slower rate. Domestically, earnings growth next year will be lower than the sharp spike in earnings that occurred this year that was largely fueled by the tax cuts. Unemployment is at a 50-year low and inflation is well within the range that is acceptable to the Federal Reserve. As a result, there is no reason for the Federal Reserve to increase short-term interest rates aggressively and thereby end the economic expansion.
While we don't see a recession in the near-term, we do acknowledge that we are closer to the end of the economic cycle than the beginning. As a result, we are becoming incrementally more defensive in client portfolios. Recently, we have added to the communication services sector and have reduced the weighting in financial companies. In addition, we have reduced corporate bonds and added to Treasury bonds.
Week in Review and Our Takeaways:
While unsettling, the volatility in the market is a normal market correction and not the start of a bear market
Next year economic growth will slow compared to this year. However, we do not see this as the start of a recession; it will simply be an economy expanding, just at a slower pace
Sources: Bernstein Analysis, FactSet, First Call